The Functional Regulation of Finance

The Harvard Law School Forum on Corporate Governance and Financial Regulation
2014-06-16

Summary:

Editor's Note:Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School of Law.

How should we think about regulating our dynamically changing financial system? Existing regulatory approaches have two temporal flaws. The obvious flaw, driven by politics and human nature, is that financial regulation is overly reactive to past crises. The Dodd-Frank Act, for example, puts much weight on reforming mortgage financing.

There is, however, a less obvious flaw: that financial regulation is normally tethered to the financial architecture, including the distinctive design and structure of financial firms and markets, in place when the regulation is promulgated. This type of grounded regulation can have value as long as it is monitored and updated as needed to adapt to changes in the financial architecture. Yet without that monitoring and updating, it can quickly become outmoded—such as occurred in 2008 when the pre-crisis financial regulatory framework, based on the dominance of bank-intermediated funding, failed to address a collapsing financial system in which the majority of funding had become non-bank intermediated.